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Wednesday, 24 September 2008

Borrowed time - the anatomy of recession

When the stock market crashed in 1929, it brought on the world's worst disaster since the First World War. In the US, it was the worst calamity to face the nation since the Civil War.
By the end of 1930, one in four wage earners was out of work. In one day in Mississippi, one quarter of the entire state was auctioned off. Prices of wheat and corn were so low, crops were left to rot in the fields. "Somebody had blundered," wrote F. Scott Fitzgerald, "and the most expensive orgy in history was over."

It was borrowed time anyhow -- the whole upper tenth of a nation living with the insouciance of grand ducs and the casualness of chorus girls. Even when you were broke you didn't worry about money, because it was in such profusion around you. Toward the end one had to struggle to pay one's share...
Now once more the belt is tight and we summon the proper expression of horror as we look back at out wasted youth ... when we drank wood alcohol and every day in every way we grew better and better and people you didn't want to know said "Yes, we have no bananas" -- and it all seems so rosy and romantic to us who were young then, because we will never feel quite so intensely about our surroundings any more.

Wars and depressions. Recessions, booms and busts. They're written about afterwards as if they're natural events over which man has no more control than we do over hurricanes and earthquakes, when they are in every way as man-made as a Monday morning hangover -- which is perhaps the very best metaphor for economic depression.
Somebody has blundered, and we're paying for it again.
With every depression, with every hangover, if we have any insight we must look back and ask ourselves, "wha' happened?" and make sure we don't do it again. What happens instead however is we wake up saying something like "Ooh, never again!" -- and within the week we're back on the turps and gibbering again about bananas, whether we have them or not.
History repeats itself, but only if we're too dumb to learn. The pattern of the twenties was replicated over the last decade; the collapse is almost a repeat of the consequent disaster; and the bailouts intended to prolong our own orgy of the last few years replicates the bailouts of Herbert Hoover's abysmal administration.
They didn't work either.
But what caused the collapse of 1929? Like every monumental hangover, the collapse was inherent in the orgy. And like that one, those responsible for the monumental blunder are shucking off the blame, and seeking even more power to do it all over again.
Financially speaking, the twenties in the US were characterised by three things: the rise of the central bank to prominence and the idea that there was a "new era of prosperity" in the air; an era of easy credit, which helped to foster the idea that a "new era of prosperity" was in the air; and the single-minded pursuit of "price stability," which led to the pumping of the money supply and all that easy credit.Sound familiar?
For almost the entire decade of the twenties, the Federal Reserve vigorously pursued a policy of "price stability." The grandaddy of all Fed Governors, Benjamin Strong -- the predecessor to Greenspan and Bernanke -- wrote in 1925,

that it was my belief, and I thought it was shared by all others in the Federal Reserve System, that our whole policy in the future, as in the past, would be directed toward the stability of prices so far as it was possible for us to influence prices.

And again in 1927, when asked in that years "Stabilization Hearings," whether the Fed could "stabilize the price level" through open-market operations and other control devices:

I personally think that the administration of the Federal Reserve System since the reaction of 1921 has been just as nearly directed as reasonable human wisdom could direct it toward that very object.

Sound familiar?
They aimed for "price stability," and they succeeded: Consumer prices and wholesale prices were stable for most of the decade. But they shouldn't have been. They should have fallen. Increased mechanisation, increases in scale and increasing productivity should have made prices fall. To keep prices up -- to keep them 'stable' -- The Fed had to inflate, and inflate and inflate again. In 1921, before their inflation of the currency began, the total American money supply was $45.3 billion. By July 1929, when the stock market first started to crack after a year-on-year expansion of the money supply (which in 1924 was as high as 11.6% !), it had exploded to $73.29 billion.
As economists CA Philips, TF McManus and RW Nelson said in 1937, "the end-result of what was probably the greatest price-level stabilization experiment in history proved to be, simply, the greatest depression."
That $28 billion, created out of thin air, had to go somewhere. Where it went, for the most destructive part, was into capital goods. Consumer prices and wholesale prices were stable, but the General Price Level (which included housing, commercial property, foods and farm products) rose considerably.Sound familiar?
Just as in the twenties, so too over the last decade, where in order to keep consumer prices "stable," the money supply had to be inflated year-on-year to conceal by inflation the productivity effects of the internet age and and of the flood of cheaper consumer goods from Asia -- and the monetary inflation blew out first in the housing market. Just as in the twenties, so too in the 'Noughties,' the expansion of the money supply squandered real wealth and led to economic destruction. And so it has been every timethe expansion of the money supply has been substituted for genuine prosperity, in the US and NZ just as surely as in Zimbabwe -- as this graph so clearly demonstrates:
We might write it as a general rule: Monetary expansion always cometh before a fall.
The flood of easy credit always has to blow out somewhere. Where it first blew out this time was the housing and mortage sector, and Jeff Perren starts a series today tracing the course of that particular sector of the disaster. (The first two parts are here and here.) But if you think, as George Bush and Ben Bernanke and Henry Paulson seem to think, that the blow-out will be contained to the housing and mortage sector, then you are even more deluded than we already have good reason to think they are.
As Frank Shostak pointed out yesterday,

The Bush administration is asking Congress to let the government buy $700 billion in bad mortgages as part of the largest financial bailout since the Great Depression. The plan would give the government broad power to buy the bad debt of any US financial institutions for the next two years. It would also raise the statutory limit on the national debt from $10.6 trillion to $11.3 trillion. At the root of the problem are not mortgage-backed assets as such but the Fed's boom-bust policies. It is the extremely loose monetary policy between January 2001 and June 2004 that set in motion the massive housing bubble (the federal-funds-rate target was lowered from 6% to 1%). It is the tighter stance between June 2004 and September 2007 that burst the housing bubble (the federal-funds-rate target was lifted from 1% to 5.25%).
Can the "rescue plan" fix the US economy, or will it plunge us into the mother of all recessions?
On account of the time lag, we suggest that the tighter interest stance of the Fed between June 2004 and September 2007 has so far only hit the real-estate market and financial institutions.
Various bubble activities that sprang up on the back of loose monetary policy between January 2001 and June 2004 are not only in the real-estate and financial sectors; they are also in the other parts of the economy.
Consequently, there is a growing likelihood that these activities will come under pressure in the month ahead regardless of the rescue package. Since these activities are the product of loose monetary policy, obviously the banks that supported them are going to incur more bad assets, which will put more pressure on banks' net worth.
Contrary to popular belief, the rescue package cannot help the economy; it will only severely weaken wealth generators. (The larger the package, the more misery it will inflict.) Hence, once the massive rescue plan is implemented, it will not prevent an economic slump but, rather, runs the risk of plunging the economy into the mother of all recessions.

Shostak is not alone in his analysis. The whole capital structure is contaminated, not just the housing and mortage sector. The easy credit has worked its way all through the capital structure like termites through your new home -- adding more weight to that structure when what producers need is to be left alone to restructure stick by stick will only extend the misery, and delay the necessary recovery.
And as for calls to regulate the "deregulated" capital markets, only a myopic drone could even take such calls seriously. As Michael Hurd points out in today's Washington Times:

I don't understand why the lesson of the recent financial meltdown is that we must return to regulation. The regulatory infrastructure we have today has been in place since the 1930s New Deal - and before.
This infrastructure was supposed to prevent such a meltdown from happening. The federal government guarantees everything. This transformed capitalism from a system in which all financial institutions are privately run - and financially responsible for their mistakes.
Deep down, business executives always knew they could appeal to the government if they made foolish decisions that cost untold billions - and that's exactly what happened.
Our mixed economy - neither capitalism nor all-out socialism since the 1930s - performed exactly as it's supposed to perform in the context of a heavily regulated market.
We could basically respond in one of two ways. One way would be to acknowledge the experiment in the mixed economy as a failure, refuse to bail out those who counted on the government to rescue them from their mistakes and evasions, and start clean with a private marketplace.
It would be painful, but there's no escaping pain after a mistake of this kind. The other alternative is what's happening now: to bail out most if not all of the failing institutions; to require American taxpayers to foot the bill; to nationalize and even further regulate what's left of the industry, where possible; and to remove still more - maybe even most, at this point - of the capital out of capitalism.
Sens. John McCain and Barack Obama don't fight over which direction in which to move. Fundamentally, they agree: We need more regulation, more government and less capitalism.
Fine. Will one of them please explain, then, how more of the system that brought us to this point is to rescue us suddenly?

Even if either was economically literate, it would be impossible. And neither of them are.UPDATE 1: Via Anti Dismal, Don Boudreaux wonders why, since the government's money supply policy is obviously so crash hot, we don't we have the same policy for steel supply. Good reading.UPDATE 2: I am in receipt of an excellent letter to the editor of the NZ Herald, in response to their appalling editorial yesterday:

Dear Sir,
In your editorial of 23 September you refer to the US government’s bailout of the financial system as “rewarding the guilty” and then note that “… when markets fail, government is the only solution.” The only truly guilty party is the party to which you are now turning to for “solutions”.
Since the creation of the Federal Reserve in 1913, there has been a significant debasement in the value of the US dollar due to the unrestrained increase in the money supply by the Federal Reserve, i.e they have been printing money. Since 2001, this has manifested itself in a housing bubble, the recent bursting of which is a healthy recognition by the market that the real value of these assets is much lower.
The seeds of the current crisis were therefore laid many decades earlier with government intervention in the market. It is they who are guilty and they should not be rewarded with additional powers to intervene, actions that will lead to the further destruction of economic wealth.
J. Darby
Auckland

What many Objectivists/Libs seem to forget is that big business has been the chief architect and cheerleader for the regulations that are supposedly designed to restrain it. They use regs to immunise themselves against competition.

So those who advocate more regulations to fix the problem, and libertarians who leap to the defense of the poor embattled corporation/'businessman', are equally misguided.

And for the really scary part of the story:This is so important a topic, that it deserves top billing!!! Hidden inside the AIG bailout funding package, surely hastily cobbled together, but carefully enough to include a totally corrupt clause, was a handy dandy clause that permits raids. The conglomerate financial firms are permitted at this point to use private individual brokerage account funds to relieve their own liquidity pressures. This represents unauthorized loans of your stock account assets. So next, if the conglomerate fails, your stock account is part of the bankruptcy process. Finally the corrupt USGovt and corrupt Wall Street houses are desperate enough to put into policy, stated by the US Federal Reserve, outlining the authorized raid of your money. Beware. -- more here

One way to see the federal rescue of the home mortgage market is to call it "the smart growth bailout." True, the proximate cause lay with profligate lending practices. The flood of mortgage money covered the entire country, irrespective of state, regional or local land use regulations. That's where the similarity stopped.

During this decade there has been an unprecedented divergence of housing prices among U.S. metropolitan areas. Generally, the difference has been associated with strong land use regulations. Where restrictions are greater, house prices rose strongly relative to incomes. Where more traditional regulation remained, house prices also rose, but only modestly.

This is illustrated by the change in the Median Multiple (median house price divided by median household income). In the more regulated metropolitan markets, it rose from 3.5 to 6.0, a 70 percent increase. In the more traditionally regulated markets, the Median Multiple rose from 2.7 to 3.0, remaining within historic norms.

Economics teaches that scarcity or rationing leads to higher prices. Smart growth policies ration land for development through the use of urban growth boundaries and prohibitions or restrictions on building on vacant land. In such an environment, higher house prices can be expected.

"The affordability of housing is overwhelmingly a function of just one thing, the extent to which governments place artificial restrictions on the supply of residential land," said Donald Brash, governor of the Reserve Bank of New Zealand (the national central bank) for nearly 15 years.

Owen, everything Wendell says is correct, and it's absolutely essential that regulatory restrictions on land are eased -- and urgently.

He seems unaware, however, of the added effect of the explosion of the money supply -- of all that credit created out of thin air.

It had to go somewhere, and as with most bubbles, it went first to the place where rising prices had already been given a kick: in the seventeenth century it was tulip bulbs; in the twenties it was Florida land; this time it was housing and land, whose prices had already been inflated due to the regulatory restrictions, and by the misconception that housing represents investment rather than consumption.

The regulatory restrictions on land supply fostered the illusion that house buying was real investment spending, when as we all know housing is an example of consumption spending.

But the current malinvestments aren't restricted only to housing and land. They're more widespread than that: the gobs of easy credit has infected the whole capital structure -- by which I mean the markets for producer goods or capital goods, and the relationship of the various 'orders' of these goods with each other.

Malinvestment has misdirected resources in these markets by all the easy credit, and needs to be urgently redirected. That's what recovery means. But these malinvestments haven't yet been exposed -- the bursting of their bubble is yet to come.

As Frank Shostak points out, the effect of the money supply manipulations has a time lag -- the explosion of credit from 2001 to 2004 and the tighter supply from 2004 to 2007 "has so far only hit the real-estate market and financial institutions," but there is still more to come.

The rest of the capital structure has its own bubbles still to shake out "not only in the real-estate and financial sectors; they are also in the other parts of the economy. "Consequently, there is a growing likelihood that these activities will come under pressure in the month ahead regardless of the rescue package."

Yes, the regulatory restriction on land needs to be cleared up, and urgently, and the problems therefrom are one of the proximate causes of the current calamity.

But the problems of meddling with the money supply are still the fundamental and underlying cause, which the Smart Growth insanity has exacerbated.

Such financial crises existed well before strong central banks, and exist in nations that lack strong central banks. The boom-bust cycle of unfettered capital markets is extremely well recorded.

" History repeats itself, but only if we're too dumb to learn."

Indeed. And for the last three generations we've avoided any repeat of a deflationary trap like the Great Depression because we now have central banks that use Keynesian economics. A remarkable success.

That you both claim that we should learn from history, and claim that we should have deflation, shows a bizarre lack of logic. Have you not thought of what deflation does to investment? Have you not considered how damaging negative and zero interest rates are?

"Such financial crises existed well before strong central banks, and exist in nations that lack strong central banks. The boom-bust cycle of unfettered capital markets is extremely well recorded..."

Then perhaps you'd care to post the extensive list of such crises occurring in the absence of some huge manipulation of the money supply so we might examine them all?

But I suspect your comments are unfounded, hence no surprise they're made anonymously.

Let me point out two further errors in your comment.

The Great Depression was not an example of "a deflationary trap." It was a prime example of what happens when the pool of real savings is wiped out through extensive malinvestment, and extensive meddling makes it near impossible to build up the pool of real savings again so as to get capital investment back on the rails again.

And I do not argue either for "deflation" or for "zero" or "negative" interest rates, whatever you might imagine these to be (and I know not who you refer to when you say "both").

What I argue for is sound money. For no inflation of the money. For interest rates to be market rates, that rise and fall based on the supply of real savings, and the investment demand for them.

The effect of such a system, backed by gold, was over most of the nineteenth century increasing productivity and gently falling prices -- which is to say increasing prosperity and effectively rising wages -- studded with occasional contractions and (when meddling was only mild) rapid recovery.

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